We feel that inflation has a direct and indirect impact on financial and real assets. That effect can arguably be seen the most directly through Inflation Indexed Notes. Here in this brief, we will outline the basics of this asset class as well as the current inflation and real rate environment.

Description, Characteristics and Opportunity Set

  • Government bonds that pay interest and appreciate with the pace of CPI.
  • They have generally been a less volatile way to access inflation protection compared to gold and other metals and resource stocks.
  • There is the opportunity to invest in US TIPS and Global Inflation Indexed Notes in sovereign countries that issue them.
  • The market is less robust and liquid than nominal Treasury Notes.

 

Unique attributes

Diversification-They have been uncorrelated to risk assets such as equities and also to other debt instruments in the past. However; they are not immune to a decline in value at the same time other risk assets are subdued by market pressure.

Inflation Hedge- They have served as an inflation hedge since their inception due to the direct principal tie to the consumer price index (CPI). Also, as the principal appreciates, the coupon rate is multiplied by the increased amount.

Dual asset class role-They fall into the “real return” and traditional bond categories.

Tax- They are free from state and local taxes.

 

Valuation

Since they have a real yield they are partly valued on the difference between that yield and that of a comparable Treasury nominal yield.

  • That difference is the “break even” or what investors expect inflation to be over the life of the bond.
  • If the investor expects inflation to be less than the breakeven rate, then all other factors aside, the nominal bond will be a better investment.
  • If the investor expects inflation to be more than the breakeven rate, then all other factors aside, the inflation linked note will be a better investment.

 

Current state of inflation and the inflation notes market

  • Real interest rates are now close to zero and set to rise only moderately, according to the IMF.
  • Similarly, the factors influencing rates in past are unlikely to reverse.
  • Ten-year real interest rates across countries fell from an average of 5½ percent in the 1980s to 3½ percent in the 1990s, 2 percent over 2001–08, and 0.33 percent between 2008 and 2012.
  • At least in the next few years, it seems unlikely that central banks will seek to push up real interest rates. As the IMF writes: “In summary, real [interest] rates are expected to rise. However, there are no compelling reasons to believe in a quick return to the average level observed during the mid- 2000s (that is, about 2 percent).”
  • Current 10-year breakeven rate is 2.21%. Expectations are a little higher than actual inflation.

 

Positive scenarios for TIPS

  • Purchase a high “real yield” and benefit from a decrease in real yields.
  • Inflation will increase the principal amount and the cash flow.

 

Negative scenario for TIPS

  • Purchase a low “real yield” and lose from an increase in real yields.
  • Deflation will allow the TIPs owner to retain the par value but there will be an opportunity cost with no inflation accruals and the chance to have bought a higher yielding nominal bond.

 

Global Inflation

American Inflation CPI 1.51 % march 2014
English Inflation CPI 1.67 % march 2014
European Inflation HICP 0.47 % march 2014
German inflation CPI 1.04 % march 2014
Japanese inflation CPI 1.51 %  february 2014
Chinese inflation CPI 2.31 % march 2014

 

It does not appear that inflation is a major concern presently as these year over year numbers indicate. Inflation indexed notes have generally not been a good performing asset class over the last year as inflation and inflation expectations have been muted in spite of the fear that the Fed’s printing press will eventually create inflation.

In our next piece we will dissect a few ETFs in this space and help determine the potential payoff as well as the inherent risks given this inflation and real rate outlook as well as the country weights within each product.

Sincerely,

Tom Koehler, CIO

 

 

 

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